The Subtle Slide into Municipal Bankruptcy

The insolvency that leads to local-government bankruptcy unfolds gradually. Public officials need to monitor and heed the early warnings.

"People don't pay attention until cities talk about bankruptcy, but by then the frog has already been boiled to death." So says David Crane, a lecturer in the Public Policy Program at Stanford University who is president of the advocacy group Govern for California and a member of the Volcker-Ravitch State Budget Crisis Task Force.

Well, they're paying attention now. In August 2011, Central Falls, R.I., filed for bankruptcy. Then, three months later, Jefferson County, Ala., became the nation's largest local-government bankruptcy, at $4.1 billion. Since the beginning of this year, three California cities have declared bankruptcy, and Moody's Investors Service, one of the nation's leading credit-rating agencies, says it expects more California cities to do so.

So what does this mean for those of us who care about cities and pay attention to politics, governance and finance? A conversation with Crane, who was a special adviser to California Gov. Arnold Schwarzenegger from 2003 to 2011, offers some fresh and useful insights.

For cities, he says, social and cultural bankruptcy come long before financial bankruptcy. At first, street cleaning is cut back from once a week to once a month, library hours are cut and some libraries are closed. Street repairs, building maintenance and vehicle maintenance are reduced. Arts and cultural programs are eliminated, park maintenance is cut back and some parks are closed, and community centers are open for fewer hours or shut down. Then come the cuts to public safety as police officers and firefighters are let go. By the time cities declare bankruptcy, services already have declined steeply and the time has come to make really hard choices--pay police or pay creditors?

Filing for bankruptcy is a legal event, with a public declaration occurring on a precise date. Insolvency, however, is a financial condition that creeps in unannounced. Cities like Stockton and Central Falls were insolvent long before they declared bankruptcy. A government that is solvent has sufficient revenue to cover its operating costs and have sufficient access to capital to be able to acquire and maintain the equipment and infrastructure needed to sustain a level of efficient and effective services that meets the expectations of its citizens. A city is insolvent when it has to reduce services below this "market" level-what San Jose Mayor Chuck Reed refers to as "service-level insolvency." Cities compete for businesses and residents. Providing services at levels lower than the market level will drive residents and businesses away, reducing the tax base and further aggravating the deteriorating financial condition.

In Crane's view, citizens bear little responsibility for the financial crisis in their cities and states. They're not paying attention to government finances; they're working to pay the bills and take care of their families, and they trust their elected representatives to manage those fiscal affairs. As for public employees, they're no different from anyone else. Of course they want to be well compensated, and they're going to take whatever they can convince the politicians to give them, but they can't control whether politicians set aside enough money to pay for the promises they make.

Once a city is in deep trouble, the only way citizens are going to be protected long-term is through bankruptcy. When a city declares bankruptcy, citizens can begin to get their services back. In bankruptcy, the city can determine the "net present value" of a reasonable stream of taxes and fees and then spread the pain among bondholders, employees and citizens to bring expenditures in line with that value.

Local-government finances are complex and are impacted not only by decisions within the government itself but also by conditions in the community and by the larger regional, state and national economies. Bond ratings tell you virtually nothing about whether or not a city is on the verge of service-level insolvency. A government's bond rating is a lagging indicator of its financial condition. Waiting for a downgrade to adopt more prudent financial practices is like waiting until your car slams into a tree before you hit the brakes.

However, tools are available that allow professional managers, good-government groups, academic policy centers, government auditors and others to undertake an analysis of a government's financial condition and present the results in plain language that citizens and policymakers can understand and use. One of the more widely used such tools is the system laid out in the International City/County Management Association publication "Evaluating Financial Condition: a Handbook for Local Government." This approach uses more than 40 indicators, some of them derived from the local government's financial information and others based on broader economic and demographic data. A second approach is a fiscal analysis tool developed by faculty at the University of North Carolina School of Government, which uses fewer indicators and only data derived from the government's audited financial statements. Lots of examples of analyses using some variation of one or both of these approaches are available on the Internet.

Responsible public officials and concerned citizens will see to it that these sorts of independent analyses are regularly conducted for their governments. Doing so will allow them to see what's going on in plenty of time to turn down the heat long before the frog starts to get warm.